Ancient cultures used to look towards the heavens and identify their myths and legends etched within the stars. While the present 88 constellations recognized by the International Astronomical Union are heavily based on the catalog authored by Ptolemy, many cultures – such as the Chinese and Maya – had their own unique constellations and star groupings.

We bring this up not because we subscribe to any astrological implications on market behavior, but rather to highlight that while the game of “connect the dots” is deeply ingrained in human behavior, the dots we connect are highly subjective.

This week, the Swiss monetary authorities scrapped the franc-euro peg it maintained. The currency shot up in value almost instantaneously, from its floor of 1.2-franc to 1-euro peg to a near 1-to-1 exchange.

Early news highlighted the bloodbath of retail FX accounts and even on the trading desks of banks and hedge funds. Of course, there are larger implications beyond financial institutions. This is where economists, investors and speculators alike begin to play “connect the dots.”

Hindsight being 20/20 makes connecting the dots in retrospect fairly easy. So how did we get here? In the depths of the euro zone crisis, demand for the franc surged. Since Switzerland has a massive export sector – driving north of 70% of the country’s GDP – the increased strength of the franc hurt the economy as it made these exports more expensive. Therefore, the Swiss National Bank established a currency ceiling by printing francs to buy foreign currencies.

While both the U.S. Treasury and the Swiss National Bank (“SNB”) were “creating money,” one was buying more stable bonds while the other was buying highly volatile foreign currency.

Arguably, recent turmoil in Russia and broader Europe has not helped. With the currency ceiling, Europeans and Russians could funnel an unlimited amount of wealth into the relatively more stable economy of Switzerland without driving up the value of the franc.

Over time, the SNB’s currency holdings have exploded to about 75% of Swiss GDP. With a huge stockpile of incredibly volatile assets, the SNB had no other choice but to abandon its ceiling.

Now we get to the trickier game: playing connect the dots going forward. The move by the SNB caught the markets largely off guard because the now stronger Swiss franc will likely hurt the economy – hence a -13.3% return this week for Swiss equities. In fact, those Swiss businesses that rely heavily on euro-denominated revenue and are running a <20% profit margin may not find themselves in the red and headed for bankruptcy.

Many argue that the move by the SNB is a clear sign that the European Central Bank will start its own bond-buying program at its January 22nd meeting. This program will add to the overall supply of Euros and create demand for government bonds: hence the weakened euro and the decreased yield in government bonds.

But beyond the obvious? Connecting the dots becomes entirely subjective and up for speculation. We may see losses posted from those lending in francs. Specifically, we’ve read reports of some European banks that have been lending in the Hungarian mortgage market using Swiss franc denominated loans. A law passed in November allowed Hungarian homeowners to convert their mortgages back to forints at a rate that now looks very cheap and could potentially expose lenders to large losses.

Perhaps more concerning is the growing fear of deflation, with year-over-year Swiss CPI having come in largely negative since late 2011. Has the SNB effectively thrown in the towel and accepted its fate?

If so, what does this foretell? Switzerland is not the only economy to be facing deflationary pressures. China, Europe, the US and Japan have all seeing slowing price increases or outright decreases.

Is Switzerland merely a bellwether for a pending global deflationary vortex? Japan’s last 20 years have arguably been the “micro laboratory” for a deflationary global scenario – and we all know how that turned out. A very scary proposition indeed.

But markets are inherently chaotic and reflexive upon themselves, like a multi-dimensional M.C. Escher drawing.

It is for this very reason why, regardless of our broader economic viewpoint, we employ a quantitative, rule-driven process to govern our investment decisions. Connecting the dots will always be a subjective exercise, and so we prefer to employ a consistent and objective process whereby we expect our portfolio positioning to change from time-to-time in response to rotational trends that may be emerging between asset classes. Whether global deflation is one of those trends remains to be seen: but we believe that having the flexibility to adapt is key to long-term consistency in performance and risk management.

Corey is co-founder and Chief Investment Officer of Newfound Research, a quantitative asset manager offering a suite of separately managed accounts and mutual funds. At Newfound, Corey is responsible for portfolio management, investment research, strategy development, and communication of the firm's views to clients.

Prior to offering asset management services, Newfound licensed research from the quantitative investment models developed by Corey. At peak, this research helped steer the tactical allocation decisions for upwards of $10bn.

Corey is a frequent speaker on industry panels and contributes to ETF.com, ETF Trends, and Forbes.com’s Great Speculations blog. He was named a 2014 ETF All Star by ETF.com.

Corey holds a Master of Science in Computational Finance from Carnegie Mellon University and a Bachelor of Science in Computer Science, cum laude, from Cornell University.

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